Eurozone breakup off the table as region inches toward recovery

It’s been four years since the European sovereign debt crisis broke out, yet troubles on the continent continue to hover like a dark cloud over markets. The Financial Post sat down with Jens Larsen, chief European economist and managing director for RBC Capital Markets, to talk about what’s in store for Europe this year.

A This isn’t too surprising. You’ve seen the general global bond movement in the last few weeks where Spanish and Italian yields have begun to head south. But this isn’t really about strong fundamentals. This is because markets have become convinced that Spain or Italy are not going to need a Greece-style bailout, and that means investors are much more willing to take a risk on these bonds.

QA year ago, everyone was expecting a Spanish or Italian bailout to happen. Then the ECB announced its unlimited bond buying program and bailout talk ceased. Do you see a Spanish or Italian bailout in 2013?

A The problem is, with the ECB having promised this mechanism and having established the mechanism, pressure has come off yields. There’s now less urgency for the Spanish government to ask for a bailout, hence, they aren’t asking. We don’t see the urgency. That’s a very clear example where ECB action has reduced market pressure and it led to inaction on the political side.

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QItaly and Germany are holding federal elections this year. Is there a risk we will see a lot of market turmoil in their wake as we did when France and Greece held elections last year?

A Turmoil is definitely possible. The market can be tested, absolutely … Of course, in Italy, you face the risk of a split parliament being elected. To me that’s the most worrying thing about the Italian situation. If they don’t have a working government, then it’s very difficult to ask the European Central Bank for help.

As for the German elections, the mere presence of them is a key shaping factor in the political outlook for this year. I think the appetite for taking great new initiatives in Q2 and Q3 will be limited, because the German government won’t want to engage in too many controversial decisions. Events might force them to have to do that, but they won’t volunteer.

QTalk of a euro breakup has also subsided. Could we see a resurgence of breakup fears again this year?

A I think it would take a big political event for that to happen. Personally, I see the next political dimension of Europe is going to be between the “euro area ins” and the “euro area outs.” [This is a reference to countries that have adopted the euro as a currency, and those that have not, such as the United Kingdom.]

For example, look at the U.K. banking system. It’s strongly integrated into the euro banking system, the French banks, the German banks, etc. It’s a very important part of the European financial infrastructure. But a lot of the decisions about that system are being made in the euro area, by euro area finance ministers. And that’s obviously a very tricky situation for those outside the euro area, such as the U.K.

QIt’s been four years since the European sovereign debt crisis began. Do you think we’re moving closer to a resolution?

A No, we’re not closer to a resolution, but we’re closer to recognizing the path that we need to be on to get there. From a financial market perspective, that’s the important thing.

The key thing to me is that Europeans are slowly but steadily putting in place the mechanisms, the institutions, and taking the steps that are necessary to address these problems. The pace is by no means impressive. It’s still a key constraint on growth, and getting growth again will take a long time. But will you be as worried, will you be spending as much time writing about Europe as you did last year? I don’t think so.

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